Spreads play a significant factor in profitable forex trading. When we compare the average spread to the average daily movement, many interesting issues arise. First, some pairs are more advantageous to trade than others. Secondly, retail spreads are much harder to overcome in short-term trading than some may anticipate. Third, a larger spread does not necessarily mean the pair is not as good for day trading as lower spread alternatives. The same goes for a smaller spread—it is not always better to trade than a larger spread alternative.
- For day trading spreads, some pairs are better than others, and drawing conclusions on tradability based on the size of the spread (large vs. small) is not useful.
- Converting the spread into a percentage of the daily range allows traders to see which pair is offering the best value in terms of its spread to daily pip potential.
- Traders actively day trading will likely trade the pairs with the lowest spread as a percentage of maximum pip potential.
- Traders can monitor daily average movements to see if trading during low volatility times presents enough profit potential to make active trading (with a spread) worthwhile.
Establishing a Baseline
To understand what we are dealing with and which pairs are more suited to day trading, a baseline is needed. For this, the spread is converted to a percentage of the daily range. This allows us to compare spreads versus what the maximum pip potential is for a day trade in that particular pair. While the numbers below reflect the values in existence at a particular period of time, the test can be applied at any time to see which currency pair is offering the best value in terms of its spread to daily pip potential. The test can also be used to cover longer or shorter periods of time.
These are the daily values and approximate spreads (spreads will vary from broker to broker) as of April 7, 2010. As daily average movements change, so will the percentage of the daily movement the spread represents. A change in the spread will also affect the percentage.
Please note: In the percentage calculation, the spread has been deducted from the daily average range. This is to reflect that retail customers cannot buy at the lowest daily bid price shown on their charts.
- Spread as a percentage of maximum pip potential: 3/102= 2.94%
- Spread as a percentage of maximum pip potential: 3/77= 3.90%
- Spread as a percentage of maximum pip potential: 4/124= 3.23%
- Spread as a percentage of maximum pip potential: 4/117= 3.42%
- Spread as a percentage of maximum pip potential: 4/62= 6.45%
- Spread as a percentage of maximum pip potential: 4/94= 4.26%
- Spread as a percentage of maximum pip potential: 6/145= 4.14%
Which Pairs to Trade
When the spread is expressed as a percentage of the daily average move, the spread can be quite significant and have a large impact on day-trading strategies. This is often overlooked by traders who feel they are trading for free since there is no commission.
If a trader is actively day trading and focusing on a certain pair, it is most likely they will trade pairs with the lowest spread as a percentage of maximum pip potential. The EUR/USD and GBP/USD exhibit the best ratio from the pairs analyzed above. The EUR/JPY also ranks high among the pairs examined. Even though the GBP/USD and EUR/JPY have a four-pip spread, they outrank the USD/JPY, which has a three-pip spread.
In the case of the USD/CAD, which also has a four-pip spread, it was one of the worst pairs to day trade, with the spread accounting for a significant portion of the daily average range. Pairs such as these are better suited to longer-term moves, where the spread becomes less significant the further the pair moves.
Adding Some Realism
The above calculations assumed that the daily range is capturable, and this is highly unlikely. Based simply on chance and the average daily range of the EUR/USD, there is far less than a 1% chance of picking the high and low. Despite what people may think of their trading abilities, even a seasoned day trader won't fair much better in being able to capture an entire day's range—and they don't have to.
Therefore, some realism needs to be added to our calculation, accounting for the fact that picking the exact high and low is extremely unlikely. Assuming a trader is unlikely to exit/enter in the top 10% of the average daily range and is unlikely to exit /enter in the bottom 10% of the average daily range, this means that a trader has 80% of the range available to them. Entering and exiting within this area is more realistic than being able to enter right into a daily high or low.
Using 80% of the average daily range in the calculation provides the following values for the currency pairs. These numbers paint a portrait in which the spread is very significant.
- Spread as a percentage of possible (80%) pip potential: 3/81.6= 3.68%
- Spread as a percentage of maximum pip potential: 3/61.6= 4.87%
- Spread as a percentage of possible (80%) pip potential: 4/99.2= 4.03%
- Spread as a percentage of possible (80%) pip potential: 4/93.6= 4.27%
- Spread as a percentage of possible (80%) pip potential: 4/49.6= 8.06%
- Spread as a percentage of possible (80%) pip potential: 4/75.2= 5.32%
- Spread as a percentage of possible (80%) pip potential: 6/116= 5.17%
With the exception of the EUR/USD, which is just under, over 4% of the daily range is eaten up by the spread. In some pairs the spread is a significant portion of the daily range when factoring in the likely possibly the trader will not be able to accurately pick entries/exits within 10% of the high and low which establish the daily range.
The Bottom Line
Traders need to know the spread represents a significant portion of the daily average range in many pairs. When factoring likely entry and exit prices, the spread becomes even more significant. Traders, especially those trading on short time frames, can monitor daily average movements to verify if trading during low volatility times presents enough profit potential to realistically make active trading (with a spread) worthwhile.
Based on the data, the EUR/USD and the GBP/USD have the lowest spread-to-movement ratio, although traders must update the figures at regular intervals to see which pairs are worth trading relative to their spread and which ones are not. Statistics will change over time, and during times of great volatility, the spread becomes less significant. It is important to track figures and understand when it is worth trading and when it isn't.